The Strongest and Weakest U.S. Housing Markets

Slide Show >>Over the next year or so, as the real estate market begins to soften, where will home prices remain highest? Potential buyers should look for more than beachfront location, nearby golf courses, or even good schools to determine whether their investment will be a smart one. The best thing to find? A strong local economy.

A quick glance at housing data from the U.S. census shows that the metro areas that are home to healthy technology, manufacturing, entertainment, or financial-services companies, as well as big employers like top universities, enjoy equally healthy property values.

Areas such as San Jose, San Francisco, and Anaheim have buyers paying nine times their median incomes on new homes. At $744,500, the San Jose/Sunnyvale/Santa Clara (Calif.) metropolitan statistical area has the highest median home sales price in the country, according to the National Association of Realtors. The reason, says Mark Zandi, chief economist for Moody's Economy.com, is that "these local economies are among the nation's most productive. Housing values are driven by the activity on the land."

DIRT: NOT CHEAP. The median home price in the U.S., according to the National Association of Realtors, is $231,000. While San Jose is at the top, the least expensive area is Danville, Ill., where the median is an anemic $67,000.

Recently, San Jose's Coldwell Real Estate branch tried to buy three acres of dirt in the country's priciest metro area for $10 million—and was denied. "Dirt—just dirt," says area broker Jack Dent, laughing. After 30 years of representing the high-tech hub, Dent says with so many headquarters for the likes of Intel (INTC), Apple (AAPL), Hewlett-Packard (HPQ), and new biotech companies in place, and high earnings potential, the demand will always be there.

In some areas, such as Silicon Valley, space is already at a premium. Surrounded by mountains and the San Francisco Bay, the Valley has no room to grow, unlike Dallas' sprawling metro area. The thing to watch here is how offshore manufacturing of high-tech products may affect economic activity. With manufacturing leaving, what's fueling demand in the nation's hot spot is more research and innovation, and headquarters presence.

PRICES EXPECTED TO FALL. While that indicates the real estate market should hold its value in the near term in areas like Silicon Valley, other, less economically fortunate places will be especially hard hit. As struggling corporate giants such as Corning (GLW) and General Motors (GM) lay off workers, local housing prices in areas such as Elmira, N.Y., or Youngstown, Ohio—GM maintains a large factory in nearby Lordstown—which are already depressed, will fall even further.

While Zandi expects housing prices to fall over the next year or two, he says home buyers looking for a bargain in the strongest areas will be, for the most part, disappointed. It takes a long time for local economies to absorb high home prices, he says. Studies have shown that the time it takes for real income to catch up with median housing prices is around 12.5 years in top market areas—at which point the housing cycle may again be in an upswing.

The result is that the number of people able to purchase homes in these areas will remain smaller for a number of years, which is bad news for homeowners who are looking to sell. The percentage of first-time buyers in California able to afford a median-priced home stood at 23% in the second quarter of 2006, compared with 30% for the same period a year ago, according to the California Association of Realtors.

SQUEEZED IN THE MIDDLE. The upside—for buyers, at least—is that even in strong areas like San Mateo, prices will begin to level out, especially as interest rates continue to inch up and real wages fail to increase. What does that mean? Well, it's pretty simple. At the extreme ends of the real estate scale, areas with high employment and high median incomes will do better than places with low employment and low median incomes. There's nothing surprising about it, and it's pretty much always been like that.

So who should be nervous? Not the people who have high-paying jobs at Google (GOOG) or Yahoo! (YHOO), that's for sure. It's the people in the middle who should be concerned. In places with only moderate growth and where the local economy is steady if unexciting, there are people who have been taking advantage of low interest rates to finance lifestyles beyond their real spending power, buying houses, cars, boats, and vacations on easy credit. As rates increase, they will find it increasingly difficult to refinance their spending habits, and many will be forced to sell their houses, cars, and boats. It's at times like those when buying a home for only $77,000 in Elmira begins to look pretty good.

To see a slide show of the five most expensive and least expensive metro areas in the U.S., click here.